How Dividend Stocks Can Protect Against Inflation

Remember when everyday products were much cheaper than they are now? That’s a real-life example of inflation, an unavoidable phenomenon that erodes the value of money by pushing prices up over time. If capital isn’t being put to work and making a return during inflationary periods, the purchasing power of investor capital is declining.

Investors have a wide range of tools at their disposal to help protect their portfolios from the ravages of inflation. Some prefer inflation-protected bonds, while others swear by commodities such as gold as effective inflation hedges. Investing in dividend-paying stocks is one of the best ways to offset, or even outpace, inflation’s degenerative effects on one’s savings.

Dividends and Inflation

While placing money in a savings account may seem like the safest investment, banks don’t pay nearly enough interest these days to compensate investors for inflation. In fact, interest rates are at record low levels, making now one of the worst times in history to let money sit in a savings or money market account (that goes for CDs too). Thus, savings are eroded in terms of future buying power, as product prices creep up over the long-term.

Dividends are payments made by some companies to shareholders, usually on a quarterly basis, which give investors a tangible return on their investment for as long as they own the stock and dividends are paid out.

Dividends are a tangible return, in that investors receive the payment while holding the stock. Capital returns — gains attained from selling the stock for more than the purchase price — require that the stock is sold and therefore the actual gain is not known until the actual sale occurs. Therefore, dividends are a great tool for determining if yearly dividend receipts more than offset the rise in consumer goods due to inflation.

Inflation is expressed as a percentage figure over a period of time. For example, according to governmental data, the inflation rate in 2011 was 3.16%. This means the cost of a basket of consumer goods, also called the Consumer Price Index (CPI), increased by 3.16% in 2011.

Dividends can also be expressed as a percentage, called the “dividend yield.” Calculate a stock’s dividend yield by dividing total dividends in a year by the current stock price. For example, if $2 in dividends are paid out per year, and the current stock price is $50, the dividend yield is 4%. If the inflation rate in that year is below 4%, the dividend yield has outpaced the negative effects inflation. If inflation is more than 4%, the dividends will only partially offset inflation.

Aside from providing a hedge against inflation, dividends also contribute largely to overall portfolio returns. Between 1926 and 2010 the S&P 500 returned 9.9% per year (compounded), and 3.96% of that total return came from dividends — more than 40% of the total return.

Partial Inflation Hedge

The average dividend yield for stocks within the S&P 500 index provides a benchmark yield investors are likely to receive for holding a basket of dividend stocks. At times, the average will outpace inflation, while at other times it may not.

In January of 2009 the S&P 500 dividend yield was 3.24%, while inflation throughout 2009 was -0.34%. Not only did the dividend yield outpace inflation, but the S&P 500 also appreciated 23.45% that year. That type of dividend yield performance, relative to inflation, does not always occur.

From January 1992 through January 2012, the S&P 500 average dividend yield managed to outpace inflation in several years. In most of those years though, the average dividend yield acted as a partial hedge, only offsetting a portion of the inflation rate.

Figure 1. Inflation (%) Vs. Dividend Yields (%) — January 1 Numbers

Keep in mind the dividend yield does not account for capital gains or losses, and only reflects the return from dividends. Through the 20-year period depicted above, dividend yields were an effective partial hedge against inflation; however, it is possible to do better.

Outpacing Inflation

It is possible to outpace inflation by selecting higher yielding dividend stocks, but investors should still be aware of value traps. The average dividend yield of the S&P 500 index is just that—an average. The dividend yield on an individual stock can vary greatly from that average, providing the capability to outpace inflation.

For example, consider Dominion Resources (D), part of the S&P 500. From 2003 to the start of 2012 the stock outpaced inflation in all but one year.

By focusing on higher dividend yielding stocks it is possible to outpace inflation over the short and longer terms. This will at times require exchanging one dividend stock for another, as dividend yields and inflation both fluctuate constantly.

While the dividend yield provides a gauge to determine how a stock is performing relative to inflation, the overall price direction of the stock is also important. If the stock price is continually falling, the high dividend is likely being offset by capital losses. Therefore, also determine the soundness of the company and the stock’s price stability before buying a stock simply because it has a high dividend yield capable of outpacing inflation.

The Bottom Line

Dividend stocks provide a great partial hedge against inflation, providing a tangible return and cash flow to the shareholder. By selecting individual stocks with higher dividend yields — but that are still stable companies — it is also possible to significantly outpace inflation. Since dividend yields and inflation are in constant flux, it is sometimes necessary to exchange one stock (or several) for another in order to continue outpacing inflation. In certain years, inflation may win, but over the long-term, by consistently picking high quality dividend stocks, it is possible to generate a higher yield than inflation.